Central banks are not known to be trigger happy. RBI
is no exception. Indeed, it has often been criticised for being much too cautious, especially when it comes to loosening its grip on capital account transactions with the rest of the world.
So, what explains the sudden move to liberalise investment by foreign portfolio investors in the debt market? Is liberalisation of shortterm, admittedly volatile, overseas flows the best remedy to tackle emerging pressure points in India’s macro-economy? More importantly, is there a danger that RBI, in its search for quick-fix remedies, might have sacrificed hard-won, longterm financial stability? Perhaps.
The clause that locked in overseas portfolio investment in government securities for at least three years— i.e. with three years’ residual maturity—has been scrapped. Foreign portfolio investors can now buy bonds with residual maturity of just one year. Their aggregate holding in government securities (G-Secs) has also been raised from 20% to 30%.
Not content with that, following on the heels of the first round of relaxations, two days later, RBI announced further relaxations to incentivise foreign portfolio investment (FPI) in corporate bonds. Remember, all this comes on top of the hike in investment limit for FPIs in GSecs and corporate bonds, announced in early April.
The net effect is two-fold. One, it turns the clock back on past efforts to incentivise long-term, rather than short-term, inherently destabilising capital flows. Two, it makes India much more attractive to those looking to make a fast buck, riding on the difference in interest rates between India and the advanced world, the infamous carry-traders who borrow funds at absurdly low rates overseas and invest, typically, in risk-free G-Secs, at 7-8%.
There is, of course, an associated exchange risk in case the rupee depreciates, since the investments are in rupee-denominated instruments. Even so, the Indian debt market, which has always been attractive for overseas investors, has now become doubly so. With possibly dangerous consequences, thanks to RBI.
The central bank has not given any reason for diluting its time-tested restrictions on FPI in rupee-denominated debt or easing restrictions on external commercial borrowings. Never mind that these have stood the country well against the worst consequences of volatile capital flows.
But it’s not hard to second guess RBI. Its decision was, undoubtedly, driven by the desire to address two key pain points facing the macroeconomy: a dramatic worsening in the external balance (both trade and current account deficit have widened significantly) and higher borrowing costs (interest rates have increased, following a spike in bond yields).
According to RBI data, India’s current account deficit (CAD) for the third quarter of the current fiscal (October-December 2017) widened sharply to end close to the danger zone of 2% of GDP, up from 1.4% in the corresponding period last year. The bland statement accompanying the data release—“The widening of the current account deficit on a year-on-year basis was primarily on account of a higher trade deficit brought about by a larger increase in merchandise imports relative to exports,”—did little to assuage growing fears over our increasing vulnerability on the external front. Not with oil prices set to rise and US interest rates likely to rise faster than envisaged earlier.
Unfortunately, just when there is growing disquiet over the external health of the economy, the internal health is also looking increasingly precarious. After a short correction, the yield on risk-free G-Secs rose by as much as 43 basis points in April. The failure of a number of recent bond auctions adds to concerns that it may not be smooth sailing for GoI’s borrowing programme.
With both the external sector and the bond market looking increasingly vulnerable, some action was clearly warranted. Never mind RBI governor Urjit Patel’s vote of confidence in the economy: “There are now clearer signs that the revival in investment activity will be sustained.” The ground reality is different.
It would appear, RBI, for all its bravado, is much less sanguine. Hence, the decision to ease restrictions on FPI inflows into the debt market. Prima facie, this is an easy option. Higher FPI inflows can help finance a burgeoning (threatening?) CAD. At the same time, increased demand for GoI/corporate debt at a time when public sector banks are staying away from government debt could help reduce the pressure on yields. (Yield and price move inversely.)
So, is this RBI’s idea of ‘prompt corrective action’ (PCA) vis-à-vis the economy? Unfortunately, as with RBI’s PCA for banks, PCA for the economy is not without costs. History does not lend much comfort when it comes to dependence on short-term debt flows. Yes, to the extent investments are in rupees, rather than dollar-denominated debt, it does mitigate the risk. But it does not eliminate it.
If and when sentiment turns against India and investors want to exit, externalising the repayments (converting into dollars) could put enormous pressure on the rupee, and imperil our financial stability.
Has RBI, in its search for easy answers, opted for a quick-fix solution that may endanger our hard-won, long-term financial stability? Only time will tell.